TIF reported earnings for its fiscal second quarter (ended July 31st) before the market opened last Friday. Ex unusual items, earnings per share were up 45% year on year. Gross margins were up by a considerable amount. European and Asia ex Japan operations boomed. Gold and platinum jewelry were up, (less expensive) silver items were flat.

Watches, the most highly cyclical of jewelry purchases, were up 30% year on year during the quarter.

Business accelerated in August.

Two flies in the ointment. Sales in the US were slightly lower than TIF expected, due to softness earlier in the quarter and on items below $500 in price. This may have been a question of tough comparisons, as TIF introduced its popular line of key pendants last year. Or it could be evidence that although the economy is slowly returning to normal for most TIF customers, things are not getting better for the 10% or so of the workforce that is still unemployed. (My money is on the latter, but then regular readers will have figured out that I think there’s a structural mismatch between the workers our educational system is churning out and the employees 21st century companies need. As an investor, though, I have to constantly remind myself not to force this interpretation on data that don’t support it.)

TIF also said that 3Q earnings growth would likely be slowed by unusually large marketing expense in preparation for the holidays, a notable portion of that in support of its burgeoning Chinese business.

TIF maintained its second half earnings guidance, but lifted its full-year expectations to reflect the better than forecast first half.

The stock fell 6% on the news. I only look at TIF out of the corner of my eye, so don’t ask me why Wall Street reacted so badly.

the details

2Q regional sales comparisons

worldwide +9%, +6% comp stores

Americas +8%, +6%

Pacific ex Japan +21%, +10%

Japan +4%, -1%

Europe +14%, +11%

the Americas

Sales momentum built during the quarter. Sales gains came predominantly from increases in transaction size. All price points were strong, except for the lowest–items under $500.

Canada, Mexico and Brazil all had healthy sales increases. In the US, softness geographically was only evident in southern California, Arizona and Las Vegas (all areas of rampant real estate speculation during the housing bubble).

More than half the growth came from foreign tourists, who account for about 15% of overall US sales.

Europe

Performance for this relatively late-blooming area for TIF were even better than they seem. On a constant currency basis (factoring out the 10% fall in the € and 7% decline of the £ against the $) European revenues advanced 25% overall and 21% on a comparable store basis.

Most sales are to locals, although TIF did see an increase in purchases from Chinese tourists.

Pacific ex Japan

As usual, greater China and Korea boomed, with sales up over 20% (even though 2009 was an up year for the region). Australia and Taiwan were relatively flat.

Japan

Once the centerpiece of TIF’s international expansion, Japan remains a tough place to do business.

my thoughts

I don’t know the stock well enough any more to have a strong opinion. Admittedly, I’ve been looking at TIF more to get a sense of what high-end retail around the world is doing than as a potential investment.

Two things have caught my eye, however:

–TIF has been trading at a market multiple for the past several years. I think it deserves better than that.

–the company has raised the dividend twice so far this year. The stock is now yielding 2.4%.

When I updated Current Market Tactics yesterday, I mentioned the August 17th speech of the President of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota. I thought I’d elaborate on it a bit today.

First, Mr. Kocherlakota. He went to Princeton (1983) as an undergraduate, and got a PhD in economics at U Chicago (1987). He taught at a number of places, the last being Stanford and U Minnesota, before being appointed President of the Minneapolis Fed last year.

Mr. Kocherlakota says the speech contains his own views, and not necessarily those of the rest of the Fed. But the Fed routinely uses occasions like this to provide background about its actions or to air its thoughts in a way that can’t draw Congressional ire in the way an “official” position might.

As I read it, the speech has several main points:

1. An economic rebound is under way, although the recovery is unusually slow and accompanied by an unusually low amount of inflation.

2. The labor market is responding only sluggishly to very stimulative money policy. How so?

The Bureau of Labor Statistics has been keeping a tally of job vacancies since December 2000. Older, but less detailed data, are available from the Conference Board for the years 1951 onward. Robert Shimer, an MIT-educated economist teaching at UChicago, has studied the relationship between the vacancy rate and the unemployment rate, publishing the results in an article frequently discussed by the Fed and cited in the printed version of Mr. Kocherlakota’s speech.

Anyway, there’s a stable, inverse relationship between the unemployment rate and the vacancy rate–the higher the unemployment rate the smaller the number or unfilled jobs and vice versa–until mid 2008. Then the relationship breaks down. Over the past year, for example, the number of unfilled jobs the economy has created has risen from 2.34 million (the low point, last July) to 2.94 million this June. But the unemployment rate went up during this time, despite the extra 600 thousand extra open jobs.

The unemployment rate should have fallen to 6.3% over the past twelve months as these new jobs were filled. Why not? Mismatch. “Firms have jobs, but can’t find appropriate workers,” as Mr. Kocherlakota put it. Mismatch can come in different forms: a worker can live in Nevada but the job can be in Florida and the worker may be unable/unwilling to sell his house or otherwise reluctant to move; the worker may be only comfortable with pencil and paper, but the job may require computer literacy; or the worker may hope against hope that his old job will magically reappear rather than starting to retrain himself.

The headline grabber of the speech is the statement that “the Fed does not have a means to transform construction workers into manufacturing workers.” I interpret this as being a strong statement about what it thinks is the problem. But it could equally well be that the Fed just doesn’t want to make specific policy recommendations about, say, housing.

3. The recent Fed decision to reinvest proceeds from mortgage-backed securities into Treasuries accidentally scared the securities markets. The reason the Fed is buying Treasuries is not that the economy is in worse shape than commonly thought, but that mortgage prepayments have been larger than anticipated (because low interest rates have prompted lots of refinancing). Because of this the Fed’s holdings of government securities have dropped below the intended level.

4. The Fed will likely begin to raise rates before the consensus thinks it’s appropriate. Standard economic theory says that money policy actions can have short-term real effects on an economy but that over time the economy adjusts to restore the pervious real status quo. The way this is usually expressed is that an inappropriate drop in interest rates can temporarily boost economic activity in a country but that growth soon moderates and the country is in the same place as before, but with higher inflation.

Mr. Kocherlakota’s point is that the long-term real rate of return on cash-like securities is around 1% annually. If the Fed holds the policy rate at effectively zero after the economy is restored to health, the economy will adjust to restore the real rate to 1%. It can only do this through deflation–by making real prices decline by around 1% a year. Sounds kind of wacky, until you think that this is a good description of what Japan has been doing for the past twenty years.

It seems to me the speech does several things:

–it provides an answer to critics who say that money policy is still too tight, by pointing to the large number of unfilled jobs available. The passage of time will eventually cure the mismatch. Government programs may speed the process up, but looser money policy will just create more unfilled vacancies.

–it implicitly criticizes the notion that more “shovel ready” projects will do any good. Again, Japan’s experience over the past twenty years is a cautionary tale. in 1990, a startlingly high 10% of Japan’s work force was employed in construction. Rather than allow/force a transition to other occupations, Tokyo launched wave after wave of make-work pork barrel public construction projects. The government also used formal and informal means to preserve the status quo in other sectors, in order to keep the unemployment rate low. What did all this get Japan–twenty years (so far) of economic stagnation, chronic deflation, a crippling amount of government debt and a tendency to rue the day that the black ships arrived at its shores.

–it signals to academic critics that it understands the negative implications of keeping the fed funds rate at zero too long.

All in all, the speech is a lot more interesting, and revealing, than the single sound byte.

According to the Bureau of Economic Analysis in the Commerce Department, the federal government collected $1.14 trillion in income tax from individuals and $231 billion from corporations last year. That compares with recent highs of $1.5 trillion for individuals (2006–although the highs continue pretty much through 4Q08) and $454 billion from corporations (2005).

(As a matter of general economic interest, though not important for what follows, the BEA data show that the low point for corporate income tax receipts was the fourth quarter of 2008, when taxes were being collected at a $192 billion annual rate. That compares with inflow at a $417 billion rate for 2Q10. For individuals, the change has been less dramatic. The low point was 2Q09 at $1,112 billion. Currently the annual rate is $1,136 billion.)

the new rules for corporates

Unlike individuals, corporations have to let the IRS know when they think they’re doing something on their tax returns that may not sit well with the agency. The “something” can be any of a multitude of potential sins. To mention just a few possibilities, it could involve transfer pricing (improperly recognizing profit in a low tax rate country rather than in the US), expensing items that should be capitalized, recording sales as capital gains other than ordinary income.

The oddity about today’s rules is that the corporation has to tell the IRS that there are items they’re not highly confident would be approved of if audited, and the dollar amount involved, but not what the items are.

According to a recent article in the New York Timesabout this topic, IRS agents assigned to looking at corporate returns can spend a quarter of their time trying to locate–presumably without much success–these questionable items. So the IRS is changing the rules. From now on, corporates will have to file a special form, Form UTP (uncertain tax positions) that will provide the IRS with a list of the items where they may have underreported income or overstated expenses.

what’s at stake?

According to the Times, publicly traded companies in the US paid $138 billion in income tax last year (the BEA number cited above includes all corporations, including ones not publicly traded). Those firms also reported questionable tax positions amounting to about 150% of what they paid.

We won’t really know how solid a number that is until reporting under the new rules commences. At present, it seems to me there’s no penalty for classifying tax treatment of a particular item as questionable, since the IRS isn’t going to find it anyway. If it’s your bad luck that the IRS does happen to stumble on your uncertain item, at least you have some private record of your honest intentions to help deflect possible accusations of tax fraud. Now the game has changed. By listing an item on Form UTP you call attention to it. But if you don’t, your protestations of good intentions are going to ring hollow. If I had to guess, mine would be that the UTP number will shrink, but not by much.

who are the biggest UTP players?

The Times points us to The Ferraro Law Firm, a Washington, DC-based company whose specialty is representing whistleblowers who report cases of corporate tax evasion to the IRS in return for a percentage of taxes recovered. FLF has created theFerraro 500, a listing of the US publicly traded companies with the largest UTPs. Until we see reporting under the new rules, we won’t know whether the firms high up on the list have the most aggressive accountants or the most conservative ones, though.

The Ferraro 500 is constructed by taking the Fortune 500, a ranking of the largest US corporations by sales, and reordering them according to who has the largest absolute amount of UTPs. The list isn’t perfect. For one thing, 21 members of the Fortune 500 don’t disclose UTPs. Also, some firms end up lessening the UTP number by allocating a portion to SG&A; some don’t (see the footnote at the very end of the Ferraro 500 list).

Then, there’s the question of what metric to use in analyzing the data. I decided, at least partly because it’s simple to do, to look at the spread between a company’s ranking in the Fortune 500 and in the Ferraro 500. Possible firms with very aggressive tax accounting would rank low on the Fortune 500 but high on the Ferraro 500. “Good” firms would be the opposite.

There are 20 corporations in the Fortune 500 that have no reported UTPs. The full list is at the tail end of the Ferraro 500, but they tend to be insurance companies or firms like Southwest Airways and the Washington Post.

Generally speaking, the companies with the smallest reported UTPs relative to their size are in the consumer discretionary and staples sectors. The ones with comparatively large amounts of UTPs tend to be public utilities, particularly energy transmission and distribution, or financial companies ex the large commercial banks.

The companies with the greatest spread between their Fortune and Ferraro rankings, meaning small sales but large UTPs, sorted by the Ferraro ranking, are:

Starwood Hotels Ferraro 41, Fortune 438

Agilent 43, 461

Amerigroup 47, 404

Avis 69, 409

Western Union 83, 413

Broadcom 100, 460

Century Telecom 114, 423

CA 115, 482

Applied Materials 116, 421

NCR 128, 451

Blackrock 130, 441

Electronic Arts 134, 494

ElPaso 144, 447.

A significant number of the members of this list, all of whom rank 300 places or more lower on Fortune’s compilation than on the large UTP one, are technology firms. Yahoo was very close to inclusion, as well. I’m not sure it’s right to make industry conclusions from this sample, however, since technology firms also feature prominently among those with relatively low UTPs.

My guess is that the stock market won’t pay any near-term attention to this change in IRS rules. I think it’s something to keep a close eye on, however. Not only could some firms have a step change down in reported earnings next year as they reassess their tax strategies, but since the IRS has three years from filing date to initiate an audit, the IRS may well use Form UTP as a roadmap for examining prior year filings as well.

The SEC wasted no time in acting on the authority it got under the recently enacted Dodd-Frank (or Frank-Dodd) Wall Street Reform and Consumer Protection Act to determine shareholder ability to add materials to proxy materials of publicly traded companies.

Yesterday it set new rules that permit shareholders to place their nominees on the ballot for election to the board of directors, providing:

–the shareholder owns at least 3% of the company’s shares,

–it has been a 3% holder for three consecutive years,

–it doesn’t hold the stock as part of an effort to change control of the firm, and

–it has no side agreement to support the existing management.

A qualifying shareholder can submit nominations for up to 25% of the board.

The new rules will go into effect in about two months.

the “system” this replaces

Any shareholder could submit names to a corporation and ask that they be considered for inclusion on the proxy ballot. But the firm had no obligation even to consider these requests, which I would imagine went directly into File 13. A shareholder wanting change could raise his objections at the annual meeting–a futile undertaking, since management would already have obtained enough proxies to control any vote. The only other alternative for an unhappy shareholder has been to wage a proxy fight, that is, to contact other shareholders directly and ask for their votes–a very expensive process.

Until July 2009, a proxy fight was an even more futile process than it sounds, since a brokerage firm could vote all the shares it held for clients in “street name” (basically, all of them) for the directors the broker desired, provided he had received no instructions from the shares’ owners. Effective with voting at meetings after January 1, 2010, brokers must either vote the shares they hold for customers in accordance with their instructions, or–without instructions–not vote them at all. Since a company’s management control the flow of investment banking business, guess who brokers tended to vote those silent shares for?

are new rules needed?

Yes, in my opinion. Think about the recent GM bankruptcy. Through 35 years of almost continual loss of market share, a complacent board defended stunningly incompetent management. Both were in denial to the very end. Both rebuffed all outside attempts to change a corporate culture of failure.

two observations–my opinions–about boards and individual shareholders

1. In theory, shareholders elect the board of directors to supervise the operation of company. Directors set strategy and hire the management that carries out the board’s wishes. In practice, the opposite is the case. Typically, management in effect controls the board both by influencing its composition and by regulating the amount and completeness of information that it supplies to board members. Many board members are managers or former managers of the company. “Independent” directors may come from politics or academia and have little experience in, or even knowledge about, the industry the company is in. All are paid for serving on the board and are indemnified by insurance against lawsuit damages for any action they may take.

It’s easy to pick a company and check. Google the board members. Ask yourself what industry background the independent directors have. What’s their “day job” and how much of their time does that take? How many other boards are they on?

2. Oddly–to me, anyway–individual shareholders tend to be intensely loyal to management and the sitting board. The invariably support management/board recommendations, even when company performance is poor and when proposals they are asked to vote on seem to very clearly run against shareholders’ interests. I’ve never gotten why. Maybe it has to do with the just-abolished practice of brokers voting clients’ stock for them.

much ado about nothing?

The consensus seems to be that the teeth have been pulled from the new voting rules by provisions two and three above, concerning change of control and three-year ownership requirement. And you might argue that even if someone gets control of a quarter of the board, they’ll still be a frustrated minority that isn’t able to crack an “old boy” board.

maybe not

1. 25% of the board is more than it seems to be at first glance. Suppose a large pension fund (the obvious large, benign holders of corporate stock) ended up with such representation on the board of a given firm. I think this would say two things: a) the company is receptive to change, and b) if you can ally with the pension fund, half the work of being able to force change through control of the board is already done. Arguably, the first step in becoming open to change, the one taken by the pension fund, is harder, so maybe well over half the work is done.

2. The new rules may change legal leverage in unusual ways. I can imagine that if a few leading pension funds begin to place directors on corporate boards, they may establish a new standard for good stewardship of pensioners’ assets. Other funds may follow suit, if for no other reason than fear of negligence lawsuits if they don’t.

Also, when a board is a closed club that speaks with one voice and provides no information about its deliberations to the public, members may feel there are no penalties for acting as a rubber stamp for management. If board minutes contain well-reasoned dissenting comments, or if a new board member is willing to make deliberations public–even to campaign against sitting board members in the next election–that may change.

Pressure on sitting board members to take an active part in the management of the company can come in two ways, I think. One is possible public embarrassment, or loss of a board seat, for members who simply collect a check from the firm (for big companies, payments to directors can be hundreds of thousands of dollars) and do nothing. Another is perhaps the greater worry that clear evidence of board members’ negligence will invalidate the liability coverage that they think protects them from the consequences of their actions.

investment implications

I think the first few proposals of alternate director candidates will be crucial in setting the tone for what will follow. It should be interesting to watch. It may well be that either the proposal itself, or the election of new board members, will be a signal for a period of stock outperformance.

I was looking through PR Newswire the other day and spotted a press release from S&P highlighting a research article on global sales data for S&P 500 companies. I decided to take a look. The reading is a little dry, but I’m glad I did. Here’s why:

1. stuff I sort of knew, but couldn’t have told you the details about

a. Today the US accounts for 16.8% of the world’s GDP, calculated on a purchasing power parity basis. I just wrote about this a short time ago, so that’s not the surprise. But although I knew the US share of world output was shrinking, I didn’t realize that at the end of 2003, the US accounted for 29.6% of the world’s economic value generation.

Wow. What a drop! Of course, the US economy has expanded over the past six years–but China and other developing countries have made enormous strides in closing the size gap. If we look at this from a relative market share perspective, the US would have been 50% bigger than its nearest rival. Now it’s one of three roughly equal economic groups–NAFTA, the EU and the BRICs. Within ten years, as I’ve pointed out in a previous post, the US will most likely be in third place in world economic rankings, behind #1 China and #2 the EU.

b. The estimates of foreign sales that the S&P produces is just that, an estimate, and is based on reporting data from 250 of the 500 companies in the index.

S&P has decided to discard data from companies that have either less than 15% of total sales outside the US, or more than 85%. That eliminates 72 companies. Of the ten firms with over 85% international sales, seven are IT firms.

The remaining 178 don’t report numbers broken out by region of the world. Some have graphs or charts, some have nothing. Of the firms reporting only US and foreign, the largest (by foreign sales) are really big names: HQP, IBM, PG, ADM, MSFT, DELL AIG, COP, CAT, AAPL, F, DOW, PEP and AMZN.

I can understand that there are issues of keeping data from competitors, as well as transfer pricing and tax planning considerations, but these firms can surely reveal to shareholders more than US vs. non-US.

2. where the growth in foreign sales is coming from

These are the foreign sales by sector of the S&P as of yearend 2009 (2008 for financials and utilities) as a percent of total sales, and the growth rate of foreign sales over the past six years:

S&P 46.6% of sales, + 11.3% since 2003

IT 56.0% of sales, + 6%

Utilities 52.2%, flat

Materials 52.1% of sales, +13%

Healthcare 47.1% of sales, +8%

Staples 46.6% of sales, +35%

Industrials 44.2% of sales, up 9.8%

Energy 43.7% of sales, -14%

Consumer discretionary 42.4% of sales, +22.7%

Financials 34.1% of sales, +19.5%

Telecom insufficient disclosure

It’s interesting to note that the fastest diversifiers away from the US over the past six years have been consumer companies. Presumably they have been propelled by a combination of he maturing of the US market and strong growth prospects in emerging economies. Staples have risen from being the sector with the lowest percentage of foreign sales, ex financials, to a first division status.

Energy is conspicuous in its sharp drop in percentage of foreign sales. I presume, but don’t know, that this is not a deliberate choice but instead a function of foreign sovereign production sharing agreements, which typically call for a decreasing percentage of production to go to the developer of a field as prices rise.

The level of foreign sales doesn’t seem to be a differentiating factor among sectors, since almost all have large foreign exposure. But the rate of growth does seem to be, if the consumer-related sectors are any indication. Given the strongly defensive nature of the market at present, it’s difficult to draw strong conclusions. As the market rebounds, however, I think it will be important to watch stock performance both vs. the level and the growth of foreign sales. My guess is that growth will be the more significant indicator.

Gavyn Davies, formerly chief economist for Goldman Sachs, then head of the BBC, is now among other things a blogger for The Financial Times.

My experience as a portfolio manager has been that Goldman’s economic commentary has always been truly excellent, and the high spot of the firm’s research offerings. As to Mr. Davies in particular, I read and admired his work for years. (Equity strategy and individual stock research at Goldman is another story—lots of facts, no useful opinions would be my call.)

The deflation problem, in a nutshell, is this: the main tool governments use to treat a sick economy is to lower interest rates to the point where the real (that is, after adjusting for changes in the price level) cost of funds is less than zero. But an agency like the Fed can only lower rates to zero, where they are now. It draws the line at actually paying us for the privilege of lending us money.

Because of this, a deflationary economy, i.e., one with a falling price level, is like having a patient with an antibiotic-resistant virus. You can’t make real rates negative. So tried and true treatment methods for curing a slumping economy are ineffective. The monetary authority can either try unconventional methods, which have no track record, or stand on the sidelines with fingers crossed, hoping the patient recovers on his own.

It doesn’t help matters that the word deflation conjures up images of the worldwide depression of the 1930s or the decades-long stagnation of Japan.

Andre Meier on deflation threats

In his post, Mr. Davies cites work by Andre Meier of the IMF in cataloging and analyzing all the instances of recessions in the developed world over the past forty years that have been serious enough to pose a deflation threat.

Mr. Meier’s conclusion: while inflation does rapidly approach the zero level in the twenty-five instances he looks at, it doesn’t seem to want to cross over into negative (deflationary) territory. The higher the previous inflation, the faster the plunge downward, but in all cases save two the rate of descent slows and the inflation rate stabilizes as the zero line is reached.

In pre-1990 instances, which tend to originate at higher inflation levels, the march to zero is relatively steady. Post 1990, the initial fall is sharp, but disinflation then tends to decelerate in later periods. In the two exceptional cases from the past paragraph, which start from very low initial levels of inflation, Sweden in 1992-94 and Japan 2001-2003, the price level actually starts to rise as the recession deepens (presumably because of currency weakness and imported commodity strength, but odd nonetheless).

conclusions

Both economists interpret the data as indicating that there’s something very unusual about the occurrence of deflation, and that it seems to take negative economic shocks of much larger magnitude than the world has seen at any time in the post-WWII era–including now–for deflation to take hold.

The question is why this is the case. Both Meier and Davies point to structural rigidities around zero. As a practical matter, firms are reluctant to cut the wages of highly skilled employees, for fear they’ll leave when economic conditions improve. They don’t want to cut the prices of their output, either. Experience has taught them that it’s extremely difficult–in many cases, nearly impossible–to raise them back again. In addition, in many cases legally binding agreements–government workers’ salaries, for example, or long-term materials supply contracts–mean price cuts aren’t possible.

On a macroeconomic level, it may be that inflationary expectations–there’ll be low inflation but at least some–have been very deeply established in our collective economic psyches. World governments response to recent crises, much as we may want to criticize the details, may have been enough to preserve or reinforce these attitudes.

In any event, the experience of the last forty years says deflation is not likely to happen.

my thoughts

No deflation doesn’t mean everything is ok. But if we take the idea that general price levels are not going to decline as a working hypothesis, we can draw conclusions that may have useful investment implications. For example, if salary levels aren’t going to decline, then firms will only be able to lower labor costs by laying workers off, or by pruning high-cost but unproductive workers and replacing them with lower-cost, more productive ones. Companies could also prioritize between high value-added tasks and low value-added ones–and focus all/most compensation increases to workers in the former areas.

One might also try to distinguish countries where limited economic gains may be a chronic problem and those (like the BRICs) where it will not.

In discussing its most recent earnings performance, Procter and Gamble seems to be saying that these sorts of patterns are already becoming evident in their customers’ behavior. For example, PG is finding that consumers of mainline/premium brands are beginning to trade up. Value-brand users are continuing to trade down.

My experience is that in uncertain economic times, investors tend to become mesmerized by worry over the worst possible outcome and do little else except wring their hands. True, we need to be concerned about even low probability events that have significant negative consequences. But typically this doesn’t take much time. I think there’s potentially a lot of money to be made by looking for hot spots of growth even in a world that may not be expanding that quickly. And there’s certainly money to be made by working out the economic implications of having something better than the worst-case scenario unfold.